Exchange Traded Funds

ASX and ASIC Educational material on ETFs

Both ASX and ASIC (via the Money Smart website) provide useful educational material, webinars and on-line training tools to assist investors in gaining a better understanding of ETFs. Copied below are links to the websites for you to access the material. It should be noted that ETFs may not be suitable for all clients, so before investing in them you should speak with your financial adviser:

• ASX website
• Money Smart (ASIC) website

What is an ETF?

An ETF is a type of fund traded on market. It can give you exposure to a wide range of assets in a single trade. Like shares, you can buy and sell ETFs on market through your stockbroker. A brokerage fee will normally be charged to purchase the ETF.

Many investors utilising ETFs do so because they are generally seen to provide easy, quick, efficient and simple diversification allied with lower costs and tax efficiency, whilst retaining all of the flexibility of trading in the manner of ordinary shares. There are two types of ETFs: physical ETFs and synthetic ETFs.

Physical ETFs

Most ETFs buy the underlying investments (such as shares and other assets) on the reference index that the ETF is seeking to track. These are known as standard or 'physical ETFs'. If you invest in an ETF, you won't directly own the underlying investments that the ETF buys (the ETF will own these); instead you will usually own units or shares in the ETF.

Your main investment risk is the performance of the ETF's underlying shares and other assets, albeit there are also other risks, which are outlined below.

Synthetic ETFs

Synthetic ETFs have a material exposure to derivatives as well as the underlying assets that the ETF is seeking to track. As well as the benefits and risks of physical ETFs such as 'price errors' and 'fees and costs', which are outlined below, synthetic ETFs have other risks to consider. ETFs offer exposure to a range of markets and assets, both domestic and international including the Australian sharemarket, overseas sharemarkets, fixed income, commodities and foreign currencies.

An ETF will typically track an underlying index. For example, if your ETF is over the S&P/ASX200 index, percentage movements in the index will ideally be mirrored by percentage changes in the price of the ETF (all things being equal).

International (Cross-listed) ETFs

ETFs that are domiciled and listed in the US and made available for trading in Australia, may require a W-8BEN form to be completed.

Returns from an ASX traded international ETF will usually come from a combination of growth and income. For Australian residents, distributions are generally taxed as foreign sourced income. US withholding tax may be deducted from distributions but investors may be able to claim an offset against the Australian tax payable on their foreign sourced income for the US withholding tax.

The US withholding tax rate is generally 30% of any distributions. Australia has a 'Double Tax Agreement' with the US, under which US withholding tax on distributions paid to Australian resident investors can be limited to 15%, if the W-8BEN form has been provided.

After purchasing an ETF, the share registrar will send the investor a W-8BEN form, which should be completed and returned to the registrar. If the form is not completed, a higher rate of withholding tax is likely to be deducted. At all times an investor should seek advice from their own Tax Adviser / Accountant to discuss their tax affairs.

Potential Benefits of an ETF

Diversification

ETFs offer diversification in one trade. For example you could obtain exposure to several hundred stocks in the index an ETF tracks. In addition, you only pay brokerage on one transaction. In contrast, attaining diversification through directly purchasing shares can be time-consuming and costly as you pay brokerage on each share purchase.

Traded on ASX

ETFs are traded on the ASX (and other markets where available), making the purchase and sale process straightforward.

Low management expenses

As index funds, ETFS are 'passively' managed and therefore management expenses are generally low. Many other managed funds are 'actively' managed where the fund manager will attempt to outperform a benchmark while an ETF will look to match the benchmark. As a result, the costs of actively managed funds will generally be higher than those of ETFs.

Tax efficient

ETFs typically have very low turnover in the portfolio, as securities are usually bought and sold only when the composition of the relevant index changes. As a result, the fund itself realises few capital gains or losses, minimising the tax impact on investors in the fund.

Income and Growth

ETFs can offer returns in the form of income and capital growth.  For ETFs over the Australian sharemarket, the fund receives dividends on the shares in the index, and passes through your portion, including any franking credits.

Potential Risks and considerations of an ETF

Market Risk

While a portfolio comprising of many securities may help protect you against the specific risk of an individual security performing poorly, you will still be exposed to the risk of the market you are invested in falling in value.

Sector Risk

If you invest in an ETF that tracks a sector index such as a resources index for example, the value of the ETF will fall in value if the resources sector performs poorly.

Currency Risk

If you invest in international ETFs or in some commodity ETFs exposure, you will be exposed to currency risk. For example, a rise in the value of the Australian dollar against the currency of the country you have exposure to can lead to a fall in the value of your ETF. As commodity ETFs are priced in US dollars, you may also be exposed to currency risk if you invest in these products.

Liquidity Risk

Liquidity can vary between different ETFs. Some are actively traded while others have relatively low turnover, which can make buying and selling at a fair price more difficult.

Tracking/pricing errors

There may be times when an ETF's price does not exactly follow the price of the index or investments it is designed to track. This may be because the portfolio of assets the ETF holds does not move exactly in line with the index being tracked.

Product Selection

Unlike investing directly, you will not be able to select what investments you want in or out of your portfolio – i.e. you will receive a portfolio that matches the ETF Index you have invested into.

Specific risks with Synthetic ETFs

Synthetic ETFs enter into contracts with third parties, or counterparties, which are usually investment banks. Your returns depend on the counterparty being able to honour its commitments to the ETF. While synthetic ETFs may or may not buy the shares and other investments that they try to match, they also use complex financial instruments known as derivatives  such as 'swap agreements'. In a swap agreement, a counterparty such as an investment bank agrees to pay the difference between the value of the ETF's assets and the value of the assets or index it is designed to track.

When the synthetic ETF enters a swap agreement, this creates counterparty risk. The swap fees may or may not be included in the ETF's 'management fee'. Check the product disclosure statement (PDS) for information about swap fees and other costs. Before investing in an ETF, check its PDS for financial information about the counterparty and how the issuer monitors and manages counterparty risk. The higher the derivative counterparty exposure level, the greater will be the proportion of the ETF's value that will be exposed to counterparty risk.

Requirements in Australia

In jurisdictions such as the European Union there can be significant risks in synthetic ETFs' derivatives and swap arrangements. However in Australia, ASIC has worked with the Australian Securities Exchange (ASX) to reduce some of these risks, including by introducing specific requirements for synthetic ETFs. Another requirement is that counterparties for any 'over the counter' derivatives used must be Australian Deposit Taking Institutions (ADIs) or an overseas equivalent (or have the benefit of an unconditional guarantee from one of these entities).

It is still possible that counterparty exposure could rise to an unacceptable level in exceptional circumstances. If this happens, the ETF issuer must take action as soon as possible to restore counterparty exposure to normal levels (for example, by requiring the counterparty to transfer cash or other liquid assets to the ETF). But if the counterparty fails financially and can't pay up, investors could lose more than 10% of the value of the fund.

Specific risks with commodity ETFs

Most ETFs that track the price of commodities (such as oil or agricultural commodities) are synthetic because they track the future’s price of a commodity or index rather than buying and tracking the price of the commodity itself. But sometimes the price of futures, and therefore the ETF's price, may vary from the value of the actual commodity. For example the price of oil indexes based on oil futures may differ from the 'spot price' for oil.

Contact us

To find out more please contact your Morgans adviser or nearest Morgans office.

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